absorption costing, overhaeds

1. LO3.1
The Cost Of materials, labour and
overheads

2. Costs

3. OVERHEAD ANALYSIS
Objectives of Cost Accounting:
To calculate the cost of any work-in-progress
To attempt to control costs by comparing actual with estimated
To estimate the cost of each product

4. Three elements of Cost
– raw materials, stationery, stores from
all departments.
– wages, salaries, commission paid to
employees.
– admin, selling, distribution and
financial expenses.
Direct Materials
Direct Labour
Other expenses

5. ‘Other Expenses'
Direct Materials + Direct Labour + Direct Expenses =
These ‘Other Expenses’ can be DIRECT or INDIRECT:
DIRECT – traceable to a particular product or job.
They vary in proportion to production.
PRIME COST

6. They fall into 3 groups –
Indirect Expenses
Indirect– these are expenses which cannot be
traceable to a particular job or product.
Normally known as
Overheads
They are essential to the running
of the business.
Manufacturing
Selling and Distribution
Administration and Financial

7. Prime Cost + Manufacturing Overheads =
TOTAL COST
PRODUCTION COSTS
Production Costs + Selling and Distribution
+ Administration and Financial =

8. COST CENTRES
• In order to control costs it is necessary to
trace them to the area responsible for the
costs.
These areas are known as COST CENTRES
A Cost Centre can be a location, person or equipment
The Cost Centre acts as a collecting place for costs eg a manufacturing
department, a machine, an operating theatre in a hospital.

9. 2 types of Cost Centre
Service Cost
Centres
– these are involved in the
manufacturing process such as
machining and assembly Cost
Centres.
– these are not involved in the actual
manufacturing process but provide
services to the production Cost
Centres such as the maintenance
and stores departments.
Production
Cost Centres

10. A Cost Unit is the final product or service being costed
• Examples of Cost Units might be:
Cost Units
a ball-bearing made on a machine
a television set manufactured
a heart transplant operation
a bus journey in terms of operating cost per passenger mile travelled

11. HOW TO TRACE COSTS TO COST
CENTRES
• Step 1
Direct Costs
– are ALLOCATED to a Cost Centre.
Power, Lighting and Heating
(when separately metered),
Repairs and Maintenance to a
machine

12. Allocation of Costs to Cost
Centres
For example, if the canteen is treated as a
separate cost centre, then the wages of the
canteen manager are allocated to that cost
centre.
Cost Allocation refers to the allotment of
whole items of overhead costs to cost
centres; that is, overhead costs can be
allocated directly to a Cost Centre.

13. Indirect Costs
A suitable basis could be:
Depreciation, Rent, Rates, Heating and
Lighting (not separately metered), Canteen
costs, Supervision etc
– are APPORTIONEDto
Cost Centres on a suitable basis.
Floor space for Heating and Lighting Number of Employees for Canteen Costs.
Cost Apportionment overhead costs are shared out among various Cost Centres
on some fair and equitable basis since the overhead cannot
be directly allocated to any one particular cost centre.

14. Apportionment of Costs
Overhead Cost Basis of Apportionment
Rent, rates, heating and
lighting
Depreciation and insurance
of plant and machinery
Canteen, factory
administration costs
Power
floor area, size of department
book value of the fixed
assets
number of employees
horse power of machines

15. Step 2
These departments exist for the whole business not just one department and
therefore these Service Costs must be APPORTIONED among the other Production
Departments, again using a suitable basis.
However, all businesses will incur
Service Costs eg
So far we have dealt with Production Department Cost Centres.
Maintenance or Personnel
Departments.

16. Basis of Apportionment
Service Overhead Cost Basis of Apportionment
maintenance man hours or value of the
capital equipment
cost of materials used or material
requisitions
number of employeesCanteen, personnel and
security guards' wages
Maintenance
Cleaning

17. Step 3
ABSORPTION OF COSTS
This is often also referred to as Overhead Recovery.
Now that Overhead Costs have been Apportioned to Cost Centres, they must
now be Absorbedinto the Total Cost.
Overhead Absorption refers to the
method of charging a proportion of
the final production cost centres'
overheads onto a particular job on
the basis of for example,
the number of labour hours or
machine hours taken to complete
the job.

18. Bases for Absorbing Overhead Costs:
Rate per Direct Labour Hour
Total Predetermined Overheads / Total Labour Hours
Machine Hour Rate: either
Total Predetermined Overheads / Total Machine Hours
when Labour Hours in the relevant
factor
Area occupied by machine –
rates, rent etc
Cost of operating – depreciation,
power etc

19. Alternative Overhead Absorption
Rates
Overheads as a percentage of Direct Wages
Overheads as a percentage of Direct Materials
Overheads as a percentage of Prime Costs
Rate per Unit Produced

20. SUITABILITY OF DIFFERENT OVERHEAD ABSORPTION OR
RECOVERY RATES
most suitable for machine
intensive jobs
Direct Machine Hour Rate
most suitable for labour intensive
jobs
Direct Labour Hour Rate
This means that the 2 most accurate methods of recovering overheads
will be:
One of the most important facts about Overheads is that they are incurred
OVER TIME.

21. All the other Overhead Absorption bases generally do not allow
for the time element but nonetheless are often used:
There is obviously no relationship between the cost of
raw materials and overheads. For example, rent and
rates and electricity do not change simply because the
cost of raw materials have changed.
Percentage of Direct
Materials
Where there is only slight variation in the rates of pay
for different grades of labour this method will produce
similar results to the direct labour rate.
Percentage of Direct Wages

22. Since the Cost units are likely to have different
production processes and different lengths of
time in the production processes it would not be
suitable to apply the same cost unit absorption
rate to all the different products produced.
Rate per Unit Produced
Same reasons as for the percentage of direct
wages and percentage of direct material
overhead absorption rates.
Percentage of Prime Cost

23. ACTUAL OVERHEADS AND PREDETERMINED/BUDGETED OVERHEADS
But since you have to charge overheads onto the job when it is done or indeed
even before it is done, particularly if the customer wants an estimate of how much
the job will cost, then you will have to use some method of "guessing" what the
overheads will be.
A difficulty in using overhead absorption or recovery rates in practice is that you will
not know what the actual overheads are until after the accounting period is finished
– for example, a month or year.

24. The way round this problem is to use PREDETERMINED or
BUDGETED Overhead Costs.
any anticipated price increases.any anticipated increases or decreases in
production, and
This is simply an estimate of what overhead costs will be in the next financial year
based on an extension of what they were in the past year after allowing for:

25. What this means is that when we come to the end of the
accounting period the actual overhead costs incurred will in all
probability differ from the overheads absorbed into the cost
units.
On the other hand, if the actual
overheads for the accounting
period are less than the
overheads absorbed then we will
have overabsorbed costs and so
we will have to make an
adjustment by crediting the gain
to the Costing Profit and Loss
Account.
If the actual overheads for the
accounting period are greater than the
overheads absorbed then we will have
underabsorbed costs and so we will
have to make an additional charge for
the difference to the Costing Profit and
Loss Account.

26. EXAMPLE – OVERHEAD UNDERABSORBED
overheads absorbedactual overheads incurred –
Overhead over / under absorbed =
budgeted overhead rateactual direct labour hours x
Overhead absorbed =
Calculate the underabsorption of overheads
5,050 hours5,000 hoursDirect Labour Hours
£52,000£50,000Overheads
Actual DataBudgeted DataCost Centre A

27. Step 1
Overhead Absorbed = 5,050 hours x £10 per hour = £50,500
Calculate the Overhead Absorbed using the rate from Step 1 and the Actual Hours
worked:
Step 2
£50,000 / 5,000 hours = £10 per Labour Hour
Budgeted Overheads / Direct Labour Hours
Calculate the Budgeted Overhead Rate based on Direct Labour Hours.

28. Step 3
As a result the Profit and Loss Account would be charged with an expense of
Overhead Underabsorbed of £1,500.
Overhead Underabsorbed = £52,000 - £50,500 = £1,500
Compare this Budgeted Cost with the Actual Cost

29. EXAMPLE – OVERHEAD OVERABSORBED
Cost Centre A Budgeted Data Actual Data
Overheads £50,000 £49,400
Direct Labour Hours 5,000 hours 4,950 hours
Calculate the overabsorption of overheads.
Overhead over / under absorbed =
actual overheads incurred – overheads absorbed
Overhead absorbed =
actual direct labour hours x budgeted overhead rate

30. Step 1
Overhead Absorbed = 4,950 hours x £10 per hour = £49,500
Calculate the Overhead Absorbed using the rate from Step 1 and the Actual Hours
worked:
Step 2
£50,000 / 5,000 hours = £10 per Labour Hour
Budgeted Overheads / Direct Labour Hours
Calculate the Budgeted Overhead Rate based on Direct Labour Hours.

31. Step 3
As a result the Profit and Loss Account would be charged with an expense of
Overhead Overabsorbed of £100.
Overhead Overabsorbed = £49,400 - £49,500 = £100
Compare this Budgeted Cost with the Actual Cost